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Underpricing, board structure, and ownership

An empirical examination of Indonesian IPO rms
Salim Darmadi
Indonesian Capital Market and Financial Institution Supervisory Agency (Bapepam-LK), Jakarta, Indonesia and Indonesian College of State Accountancy (STAN), Tangerang Selatan, Indonesia, and

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Received 4 April 2012 Revised 29 April 2012 Accepted 13 September 2012

Randy Gunawan
Indonesian Tax Ofce (DJP), Jakarta, Indonesia
Abstract
Purpose The purpose of this paper is to examine whether and how underpricing is associated with board structure and corporate ownership among rms conducting initial public offerings (IPOs) in the Indonesian equity market. Design/methodology/approach To capture the most recent development, the sample comprises 101 rms conducting IPOs in Indonesias primary equity market in the period of 2003-2011. The explanatory variables consist of board size, board independence, ownership concentration, and institutional ownership. In further analysis, the authors perform regressions considering three types of the controlling shareholder, namely families, foreign entities, and the government. Findings Providing some support for signaling theory, it is found that board independence is positively related to the level of underpricing. Further, this study provides evidence that the level of underpricing is negatively associated with both board size and institutional ownership, indicating that these two governance mechanisms play important roles in mitigating information asymmetry between the issuer and potential investors. Ownership concentration is insignicant in explaining the rst-day returns. When the type of corporate control is taken into account, it is revealed that government-controlled companies tend to experience higher underpricing. Originality/value This paper contributes to the IPO underpricing literature since the inuence of corporate governance mechanisms on initial returns is relatively under-researched, particularly within the context of emerging markets. Keywords Board structure, Corporate governance, Indonesia, IPO, Ownership, Underpricing, Emerging markets Paper type Research paper

The views expressed in this paper are those of the authors and do not represent the views of the authors institutions, namely Bapepam-LK and DJP. The authors gratefully acknowledge useful comments from the anonymous reviewer and participants at the 2012 Airlangga Accounting International Conference in Bali, Indonesia.

Managerial Finance Vol. 39 No. 2, 2013 pp. 181-200 q Emerald Group Publishing Limited 0307-4358 DOI 10.1108/03074351311294016

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1. Introduction In an initial public offering (IPO), an entrepreneurial rm offers a portion of its shares to the public or potential investors to meet its nancing needs. As suggested by Certo et al. (2001), an IPO represents an important transition point in a rms development, since the rm moves from being privately held towards being publicly held. In the so-called nancing hierarchy formulated in pecking-order theory, the IPO appears to be a rms nancing source after internal nancing and debt (Myers, 1984). A rm may enjoy a number of advantages from going public, which enables it to obtain additional funding without exposed to risks that may otherwise arise from debt, encourage greater transparency and accountability, and leverage its visibility and reputation in the market (Caselli, 2010). On the other hand, an IPO may also make a rm bearing additional costs, including loss of control, professional fees, obligations to fulll capital market regulations, and underpricing (Ibbotson and Ritter, 1995; Damodaran, 2010). IPO underpricing, which refers to stock returns experienced during the initial trading day in the secondary market, reduces the capital received by an IPO rm through the IPO process (Lin and Chuang, 2011). The pervasiveness of underpricing across markets around the world has been attracting wide attention from scholars, which can be seen from a large number of studies addressing the underpricing phenomena in the nance literature. Rock (1986) suggests that underpricing occurs because of information asymmetry between issuers and potential investors; hence a discount price is offered to attract investors. Beatty and Ritter (1986) indicate that a higher level of underpricing belongs to rms that have more uncertainties. As such, IPO rms that are subject to more asymmetric information will need a greater degree of underpricing (Johnston and Madura, 2009). Additionally, Leland and Pyle (1977) contend that underpricing is used by the issuer to signal the quality of the issue. Prior studies on underpricing, many of which are based on signaling theory, have addressed various aspects employed by IPO rms in signaling the quality of the issue, thereby mitigating information asymmetry; including the proportion of shares retained by the issuer, underwriter reputation, auditor reputation, and nancial performance. However, the association between underpricing and corporate governance attributes receives relatively little attention in the literature, particularly using the context of Asian economies (Yong, 2007). Corporate governance includes various internal and external mechanisms to mitigate agency conicts, which may arise between managers and shareholders in rms whose ownership is diffused among a large number of shareholders (Jensen and Meckling, 1976); or between the controlling shareholder and minority shareholders in rms with concentrated ownership structure (Shleifer and Vishny, 1997). Following prior studies (Baysinger et al., 1991; Shivdasani, 1993), the present study focuses on two corporate governance structures, namely board characteristics and ownership structure. The association between board characteristics and underpricing has been examined by Finkle (1998), Certo et al. (2001), and Howton et al. (2001), among others; while how ownership structure is related to underpricing has been investigated in such studies as Booth and Chua (1996), Filatotchev and Bishop (2002), and Bruton et al. (2010). It is important to note that the existing studies are mostly conducted within the context of developed economies. Evidence from emerging markets is quite rare, among the few are Chen and Strange (2004), Lin and Chuang (2011), and Yatim (2011), which use a sample of IPO rms in China, Taiwan, and Malaysia, respectively.

Given different institutional environments in emerging markets, the inuences of corporate governance variables on underpricing may differ from those in their developed counterparts. Moreover, underpricing among IPO rms in developing economies is generally higher than that in their developed counterparts (Venkatesh and Neupane, 2005). The present study aims to investigate the association between corporate governance, indicated by board structure and corporate ownership, and underpricing of Indonesian IPO rms. Indonesia is of interest in this study due to its economic signicance; the country is the largest economy in Southeast Asia and the 18th-largest in the world. Alternatively, Indonesia is home to one of the emerging capital markets in the Asia-Pacic region, attracting ever-growing foreign portfolio investments. The Stock Composite Index of the Indonesia Stock Exchange (IDX) is consistently listed among the best-performing indices in Asia in recent years. As also found in other developing economies, the Indonesian capital market is featured by weaker institutional environments, a lower degree of investor protection, and an inactive market for corporate control (Claessens and Fan, 2003), as well as higher levels of ownership concentration and family control of its listed corporations (Claessens et al., 2000). Further, the Indonesian legal system inherits many aspects of the Dutch civil law. For example, corporations are required to have two boards in their organizational structure, namely the supervisory board and the management board. The remainder of this paper is structured in the following manner. The next section reviews prior studies in the literature and develops hypotheses. This is followed by Section 3, which describes the data and methodology employed in this study. In Section 4, empirical results are reported and further discussed. Section 5 concludes the paper. 2. Literature review and hypothesis development 2.1 Theoretical review of IPO underpricing From empirical evidence suggested by prior studies, IPO underpricing is pervasive across markets around the globe. Rock (1986) argues that underpricing occurs because of information asymmetry that exists in an IPO between informed and uninformed investors. This information asymmetry leads to the so-called winners curse, since informed investors will compete for good issues, leaving uninformed investors exposed to higher probability of obtaining bad issues. Hence, Rock suggests that an IPO rm offers a discount on its share price to attract investors. However, as Chen and Strange (2004) explain, the Rocks adverse-selection model face challenges due to unclear division between informed and uninformed investors, as well as the pervasiveness of oversubscriptions in IPOs across markets. According to signaling theory (Leland and Pyle, 1977), due to information asymmetry existing between the issuer and potential investors, rms send signals to demonstrate their superior quality. They argue that equity retention by original shareholders can be regarded as a good signal of rm value to potential investors, because principal-agent conicts that may arise when the ownership of a rm is dispersed can be minimized. Other signals used by IPO rms to convey information on their high quality include the reputation of the external auditor (Titman and Trueman, 1986) or the reputation of the investment banker (Carter et al., 1998b). Further, Allen and Faulhaber (1989) extend the work of Leland and Pyle and suggest that rms tend to underprice their share in IPOs as a signal of superior quality to potential investors. Through a discount of its offer price in an IPO, an issuer indicates that its nancial position is sound and that losses incurred

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from underpricing can be recovered. As contended by Garnkel (1993), high-quality IPO rms generally have favorable private information regarding their prospects, which may be revealed in the future. To communicate their high quality to potential investors, they may perform certain strategies, including setting a low offer price. Within the corporate control framework, underpricing may also be determined to control potential monitoring on the rm. As contended by Brennan and Franks (1997), through underpricing, managers may strategically arrange the allocation of shares among new investors, so that they can continue extracting private benets. To avoid a new large shareholding that enables effective monitoring on the rm, managers choose to determine a low offer price to allow oversubscription, so that shares allocation can be rationed and discriminated. In contrast, Stoughton and Zechner (1998) suggest that managers may choose to allocate a high proportion of shares to a single investor to encourage better monitoring, thereby enhancing rm value. A low price may be offered to attract potential large investors. 2.2 Board structure and underpricing In modern corporations, where the separation between ownership and control exists (Berle and Means, 1932), agency problems may occur due to lack of alignment between managers and shareholders (Jensen and Meckling, 1976). In rms whose ownership is concentrated in the hand of a single large shareholder, the condition may be different. On the one hand, concentrated ownership may align the interests of managers and shareholders. On the other hand, such ownership structure may enable the controlling shareholder to expropriate the rms wealth at the expense of minority shareholders (Shleifer and Vishny, 1997). Given this condition, various corporate governance mechanisms, including the board of directors, play important roles in mitigating agency conicts between managers and shareholders or between controlling and minority shareholders. Researchers generally consider three characteristics of the board, namely board size, board independence, and role duality. However, since Indonesia adopts two-tier board structure, role duality does not appear to be an issue due to separate membership between supervisory and management boards[1]. Pearce and Zahra (1992) and Dalton et al. (1999) argue that board size is one of the important determinants of effective corporate governance. As argued by Lipton and Lorsch (1992) and Jensen (1993), smaller boards are more effective, since larger boards tend to lead to coordination and decision-making problems. When board size becomes too large, the board will be more symbolic and is less likely to be part of decision-making process (Hermalin and Weisbach, 2003). However, it is also argued that larger boards bring advantages for the rm, especially complex rms. Such rms have greater advising requirements, leading to the need of larger boards, which potentially have more experiences and expertise (Dalton et al., 1999; Coles et al., 2008). Additionally, large boards can also provide more effective monitoring, thereby discouraging management from extracting private benets (Boone et al., 2007). Within the context of IPOs, previous studies show mixed results. Carter et al. (1998a) and Certo et al. (2001) show that board size and underpricing are negatively related. Hearn (2011) conjectures that larger boards are positively associated with the level of underpricing, reecting asymmetric information costs arising from coordination and decision-making problems. He nds limited evidence on such a positive association. Other studies, however, fail to nd any signicant relationship between the two,

including Howton et al. (2001) and Lin and Chuang (2011). Based on the signaling theory, if board size is used to signal a rms quality, then the level of underpricing should be positively related to board size. However, in the present study, similar to Yatim (2011), we predict that larger boards indicate that uncertainties can be reduced due to more effective monitoring (Boone et al., 2007). Hence, the rst hypothesis is stated as: H1. There is a negative association between board size and IPO underpricing. With respect to the boardroom, another governance mechanism widely addressed in the literature is board independence. Jensen and Meckling (1976) and Williamson (1985) argue that boards dominated by outsiders may help mitigate agency issues by monitoring management more effectively, so that the rms wealth is not expropriated at the expense of shareholders. In rms with more concentrated ownership structure, outsiders in the boardroom are also expected to control opportunistic behavior of the controlling shareholder at the expense of other shareholders (Shleifer and Vishny, 1997; Anderson and Reeb, 2003). In contrast, boards dominated by outsiders may also lead to overmonitoring and stie strategic actions (Fama and Jensen, 1983; Baysinger and Butler, 1985; Goodstein et al., 1994). Within the IPO context, Lin and Chuang (2011) indicate that the proportion of independent outside directors is negatively and signicantly related to underpricing of Taiwanese IPO rms. Evidence from the UK is provided by Filatotchev and Bishop (2002), which consider board independence a dichotomous variable, equaling 1 if the proportion of nonexecutive directors on the board is greater than 33 percent. They nd that the variable negatively inuences IPO underpricing. However, Yatim (2011) fails to nd any signicant association in Malaysia. In a weaker institutional environment like Indonesia, independent commissioners are expected to conduct effective monitoring roles and protect the interest of minority shareholders. Within the IPO context, they are expected to mitigate agency issues between the controlling shareholder and other shareholders (Lin and Chuang, 2011), as well as to communicate information to potential new investors, thereby reducing information asymmetry (Espenlaub and Tonks, 1998). This expectation is then formulated in the second hypothesis: H2. There is a negative association between board independence (the proportion of independent members on the supervisory board) and IPO underpricing. 2.3 Ownership structure and underpricing Lemmon and Lins (2003) contend that ownership structure is a fundamental determinant of the extent of agency problems between insiders and outsiders, which may in turn affect the rms valuation. The conventional concept of agency problems state that there is a lack of alignment between managers and shareholders, where managers may pursue their own interests, negatively affecting the maximization of shareholders wealth ( Jensen and Meckling, 1976). This condition is referred to as Agency Problem I. However, such a condition is found in rms with dispersed ownership structure, where shares are distributed among a large number of shareholders. As documented by La Porta et al. (1999), dispersed ownership structure of listed rms is a phenomenon commonly found only in a few markets, such as Canada, Ireland, Japan, the UK, and the USA. Outside those few economies, the ownership structure of listed rms tends to be more concentrated, where a controlling shareholder have effective control of the rm. Given the concentrated ownership structure, agency

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problems may arise due to the lack of alignment between the controlling shareholder and minority shareholders (Shleifer and Vishny, 1997), later referred to as Agency Problem II. The nding of La Porta et al. is supported by regional studies conducted later, such as Claessens et al. (2000) on East Asia and Faccio and Lang (2002) on Western Europe. In short, these studies have documented that concentrated ownership appears to be the norm of corporate governance worldwide. As Li and Simerly (1998) argue, concentrated ownership is perceived as a monitoring mechanism, so that the interests of management and shareholders can be aligned, thereby enhancing rm value and benetting minority shareholders. On the other hand, the controlling shareholder might extract private benets, leading to costs for minority shareholders (Shleifer and Vishny, 1997). Demsetz and Lehn (1985) also suggest that concentrated ownership can lead to poor performance due to the rms large exposure to business risks. When large shareholding is associated with corporate performance, a number of studies nd a positive relationship, such as Holderness and Sheehan (1988), McConnell and Servaes (1990), and Joh (2003). Other studies, however, nd no signicant association between ownership structure and rm performance, including Demsetz and Lehn (1985), Demsetz and Villalonga (2001), and Weir et al. (2002). Empirical results provided by studies examining IPO underpricing are also ambiguous. Based on a sample of Australian IPO rms, Pham et al. (2003) nd a negative association between the shareholdings of top 20 investors. In China, the proportion of shares held by the largest shareholder is also found to negatively inuence IPO underpricing (Chen and Strange, 2004). In contrast, Venkatesh and Neupane (2005) fail to nd any signicant association between ownership concentration and underpricing in the context of Thai IPO rms. In formulating the third hypothesis, we take two matters into account. First, equity retention may be used as a signal of good quality (Leland and Pyle, 1977). Hence, a higher fraction of shares retained by insiders should be associated with a higher IPO return. Second, the controlling shareholders of Indonesian IPO rms generally tend to maintain their effective control. As suggested by Chandler (1980) and Brennan and Franks (1997), the issuer might choose to underprice IPO shares, which allows oversubscription and enables the controlling shareholder to avoid new large shareholdings. As such, based on these considerations, the third hypothesis is stated as: H3. There is a positive association between ownership concentration and IPO underpricing. The participation of institutional investors in corporate ownership is believed to lead to improved rm value due to more effective monitoring (Shleifer and Vishny, 1986). With resources and expertise they have, institutional investors have stronger incentives to monitor management, preventing managers from making suboptimal decisions and behaving opportunistically (Tihanyi et al., 2003; Velury and Jenkins, 2006). Gillan and Starks (2003) highlight that institutional investors, particularly foreign institutional investors, play an important role in improving corporate governance worldwide. Similarly, Claessens and Fan (2003) contend that the participation of institutional investors might improve corporate governance practices in East Asian rms, due to its role in mitigating agency conicts between the controlling insiders and outside investors that arise from high ownership concentration. Among IPO rms, Bird and Yeung (2010) and Lin and Chuang (2011) nd the positive inuence of institutional ownership on IPO underpricing, using Australian

and Taiwanese data, respectively. On the other hand, Kiymaz (2000) suggests a negative association based on a sample of Turkish IPO rms. For the Indonesian case, institutional investors generally have only a small portion of the shares of listed rms. In privately held rms (including IPO rms), the presence of institutional investors are infrequently observed. Hence, we predict that institutional investors in IPO rms will contribute to mitigating agency issues between the controlling shareholder and minority shareholders, thereby improving corporate governance practices. In addition, the presence of institutional investors may reduce information asymmetry between the issuer and potential new investors, so that the issuer does not need to set a signicantly lower offer price to attain the success of its IPO. Based on the prediction, we formulate the following hypothesis: H4. There is a negative association between institutional ownership and IPO underpricing. 3. Research methods 3.1 Sample and data collection To capture the most recent development of Indonesian IPOs, the initial sample of the present study consists of all rms that conducted IPOs in the countrys primary equity market from 1 January 2003 to 31 July 2011. There are totally 130 rms in the initial sample. We further exclude rms with incomplete data, resulting in 101 rms meeting our selection criteria. Data on the offer price, board characteristics, ownership structure, and nancial accounts are obtained from the IPO prospectuses of the sample rms, which are downloadable from Bloomberg, a capital market data provider. To compute underpricing, data on the rms share price on the rst trading day on the secondary markets are also required. Such data are obtained from both Bloomberg and Yahoo! Finance (http://nance.yahoo.com) to enhance validity. 3.2 Statistical model and variable measurement Cross-sectional regressions are performed to test research hypothesis. In addition to four explanatory variables highlighted in Section 2, control variables are also included in the model. Thus, the model is specied as follows: IPO underpricing b0 b1 logboard size b2 board independence b3 ownership concentration b4 institutional ownership d1 control variables 1

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Underpricing is measured using initial returns, calculated as the closing price on the rst trading day on the secondary market minus the offer price, divided by the offer price (Certo et al., 2001; Arthurs et al., 2008). Board size is the natural log of the number of people holding seats in the boardrooms. Due to Indonesias two-tier board system, we combine the members of both the Board of Commissioners and the Board of Directors. Board independence is measured by the number of independent commissioners divided by the number of all members of the Board of Commissioners. Following Chen and Strange (2004) and Lin and Liu (2009), ownership concentration is the proportion of common shares held by the largest shareholder. In further analysis, we substitute this variable with the type of corporate control. Institutional ownership is the proportion of common shares held by institutional investors. Following previous studies

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( Jennings, 2005; Cornett et al., 2007; Aggarwal et al., 2011), institutional investors are dened to be professional money managers, including mutual funds, insurance companies, pension funds, banks, investment companies, and investment advisors. Based on previous studies, as suggested by Yong (2007), we include a number of control variables, namely rm size, return on assets, rm age, auditor reputation, and underwriter reputation. Firm size is measured by the book value of assets. ROA is dened to be net income divided by the book value of assets. Firm age is measured by the number of years since a rm is incorporated, when it goes public. Auditor reputation is a dichotomous variable, which equals 1 if the rm is audited by audit rms afliated to the Big 4 (Ernst & Young, PricewaterhouseCoopers, KPMG, and Deloitte) and 0 otherwise. Underwriter reputation is also dichotomous, equaling 1 if the rms IPO is underwritten by Top 5 underwriters and 0 otherwise. The ranking of underwriters is retrieved from Bloomberg, where the underwriters are ranked based on the value of securities issues they underwrite during the sample period. The Top 5 underwriters are Danatama Makmur, Danareksa Sekuritas, Bahana Securities, Mandiri Sekuritas, and Credit Suisse. Table I provides the operationalization of variables employed in this study. 4. Results and discussions 4.1 Descriptive statistics Table II reports the descriptive statistics of our research variables. Initial returns of the Indonesian IPO rms in the 2003-2011 periods seem to vary greatly, ranging from 2 44.8 to 70 percent, with the mean and median values of 22.2 and 12.5 percent, respectively. The number of people serving in the boardrooms is 8.56, on average. With respect to the proportion of independent members on the Board of Commissioners, we nd that most rms already have independent commissioners, with the average and median proportions of 38.9 and 37.5 percent, respectively. Even though privately held
Variable Operationalization

Table I. Operationalization of research variables

Dependent variable Underpricing Closing price on the rst trading day on the secondary market minus offer price, divided by offer price Board structure Board size Number of people serving on the Boards of Commissioners and Directors Board Number of independent commissioners divided by the number of Board of independence Commissioners members Share ownership Ownership Proportion of common shares held by the largest shareholder concentration Institutional Proportion of common shares held by institutional investors ownership Firm-specic characteristics Firm size Book value of total assets Protability Net income divided by the book value of total assets Firm age Number of years since the rm is incorporated Auditor reputation Dichotomous with 1 if the rm is audited by Big 4 auditors and 0 otherwise Underwriter Dichotomous with 1 if the rms IPO is underwritten by Top 5 underwriters and reputation 0 otherwise

Variable Underpricing Board size Board independence Ownership concentration Institutional ownership Firm size (IDR billion) ROA (%) Firm age Auditor reputation Underwriter reputation

Number of observations 101 101 101 101 101 101 101 101 101 101

Mean

Median

SD 0.259 3.568 0.130 0.224 0.169 14,149 25.463 17.03 0.48 0.49

Minimum 2 0.448 4 0.000 0.229 0.000 22 2 22.900 1 0 0

Maximum 0.7000 28 0.667 1.000 1.000 93,058 253.770 108 1 1

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0.222 0.125 8.564 8 0.389 0.375 0.772 0.845 0.042 0.000 4,928 989 6.248 2.500 19.97 15 0.36 0 0.40 0

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Notes: This table reports the descriptive statistics of research variables; see Table I for variable denitions

Table II. Descriptive statistics

rms are not required to have independent commissioners, it seems that IPO rms tend to have independent commissioners to indicate their readiness to fulll capital market regulations. Indonesian listed rms are required to have independent commissioners of at least 30 percent of the number of Board of Commissioners members. All IPO rms included in our sample have concentrated ownership structure, where the range of the proportion of shares held by the largest shareholder is from 22.9 to 100 percent, whereas the average proportion is 77.2 percent. Institutional investors show relatively weak presence in Indonesian IPO rms, with the average and median proportions of institutional ownership being 4.2 percent and zero, respectively. With respect to control variables, the book value of assets varies greatly, ranging from Indonesian Rupiah (IDR) 22 billion to IDR 93,058 billion. Additionally, the sample rms generally show a relatively high level of protability, with the average ROA recorded at 6.25 percent. There are a number of rms recorded accounting losses when conducting the IPO. 4.2 Correlation analysis The result of correlation analysis is reported in Table III. Signicant correlations are found between underpricing and two variables, namely board independence and institutional ownership. Underpricing is positively and signicantly correlated with board independence, implying that IPO rms with a higher proportion of independent commissioners a more likely to experience higher underpricing. As such, the direction is contrary to that predicted in H2. This result will be further tested in our regression analysis. In addition, IPO underpricing is negatively and signicantly correlated with the proportion of shares held by institutional investors, providing preliminary support for H4. This suggests that institutional investors play an important role in mitigating information asymmetry between the issuer and potential investors in an IPO. 4.3 Regression analysis The present study performs cross-sectional regressions analysis to test research hypotheses. The results are presented in Table IV. Before running regressions, models are tested rst to assure that they do not suffer from multicollinearity and

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1. Underpricing 2. Board size 3. Board independence 4. Ownership concentration 5. Institutional ownership 6. Firm size 7. ROA 8. Firm age 9. Auditor reputation 10. Underwriter reputation 1.000 2 0.134 2 0.234 * * 2 0.194 * 0.452 * * * 2 0.003 0.197 * * * 0.196 * * 0.242 * * 1.000 2 0.033 0.001 0.112 0.046 2 0.222 * * 2 0.067 2 0.002 1.000 2 0.112 2 0.102 0.057 2 0.094 2 0.081 0.011 1.000 2 0.185 * 0.014 0.015 0.041 2 0.057

Notes: Signicance at: *10, * *5 and * * *1 percent levels, respectively; this table reports Pearson correlation coefcients between research variables; see

Table I for variable denitions

Table III. Correlation matrix 1 2 3 4 5 6 7 8 9 10 1.000 2 0.162 0.212 * * 0.073 2 0.177 * * 2 0.141 0.115 2 0.192 * 2 0.283 * * * 2 0.226 * * 1.000 2 0.061 0.349 * * * 0.190 * 0.173 * 1.000 2 0.026 2 0.049 2 0.064 1.000 0.103 0.162 1.000 0.327 * * * 1.000

Model (1) Intercept Board size Board independence Ownership concentration Institutional ownership Firm age Protability Firm size Auditor reputation Underwriter reputation Number of observations R2 Adjusted R 2 F-statistic 101 0.107 0.069 2.864 * * 0.331 * (1.490) 2 0.124 * * (2 1.706) 0.377 * * (2.022) 0.018 (0.153) 2 0.383 * (2 1.581)

Model (2) 0.428 * * (1.718) 2 0.120 * (2 1.658) 0.333 * * (1.682) 2 0.004 (2 0.031) 2 0.377 * (2 1.583) 2 0.030 (2 1.152) 0.001 * * (2.271)

Model (3) 0.423 (0.857) 2 0.054 (2 0.703) 0.335 * * (1.890) 0.006 (0.045) 2 0.348 * (2 1.544) 2 0.032 (2 1.165) 0.001 * (1.609) 2 0.002 (2 0.135) 2 0.101 * * (2 1.990) 2 0.074 * (2 1.428) 101 0.196 0.116 2.460 * *

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101 0.126 0.071 2.269 * *

Notes: Signicance at: *10 and * *5 percent levels (one-tailed), respectively; robust t-statistics, based on heteroskedasticity-consistent standard errors, are in parentheses; this table reports ordinary least squares (OLS) regressions of underpricing on board structure and share ownership; see Table I for variable denitions

Table IV. Regression of underpricing on board structure and share ownership

heteroskedasticity problems. All models use standard errors corrected for potential heteroskedasticity problems. Pearson correlation coefcients shown in Table II indicate that multicollinearity problems generally do not exist. However, a number of coefcients indicate a relatively strong correlation, for example between board size and rm size. Hence, we perform three different regressions. Model (1) address explanatory variables but not control variables. Model (2) includes both explanatory and control variables with no potential multicollinearity issues. All explanatory and control variables are considered in Model (3). Providing support for H1, board size is found to be negative and signicant in both Models (1) and (2). The insignicance of board size in Model (3) is perhaps due to potential multicollinearity with other variables. This negative association is consistent with Carter et al. (1998a) and Certo et al. (2001). Since larger boards are expected to provide more effective monitoring (Boone et al., 2007), investors may perceive a large board of an IPO rm to be able to mitigate information asymmetry. In addition, it may be believed that larger boards enable rms to better deal with the complexity of their business operations, thereby reducing uncertainties about rm value. Hence, in demonstrating the quality of the issue, a high-quality IPO rm tends to use signals other than large board size.

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The proportion of independent commissioners is signicant at the 5 percent level in the three models. However, the direction is contrary to our expectation, contradicting the ndings of Filatotchev and Bishop (2002) and Lin and Chuang (2011). This nding seems to suggest that independent commissioners of Indonesian IPO rms fail to play an important role in mitigating information asymmetry between the issuer and potential investors. Due to the countrys relatively weaker corporate governance system, independent members in the boardrooms may be dominated by insiders or management (Demb and Neubauer, 1992), preventing them from being actively engaged in communicating information to potential investors. From the markets point of view, investors may perceive a higher proportion of independent commissioners as a signal of quality, representing good intention of an IPO rm to fulll capital market requirements, as well as to protect the interests of minority shareholders by appointing outsiders to hold seats on the board. Within the signaling theory framework, this result also suggests that a high-quality IPO rm may choose greater board independence to signal its quality to potential investors. The fraction of shares held by the largest shareholder is found to be insignicant in the three models. Hence, H3 is not supported. Supporting the nding of Venkatesh and Neupane (2005), this nding implies that ownership concentration does not act as a signal of the quality of the issue to potential investors. In other words, investors may not see ownership concentration as an indicator that an IPO rm is of high quality. Further, the insignicant coefcient of ownership concentration also contradicts the proposition based on Brennan and Franks (1997), which contend that the issuer underprices IPO shares to allow oversubsription and avoid new blockholdings. This proposition seems not to apply within the case of Indonesia, since the proportion of shares offered to the public in an IPO is generally low, thereby preventing new large shareholdings that can impose additional monitoring on the rm. In her Indonesian study, Martani (2003) reports that the proportion of shares offered to the public by Indonesian IPO rms is approximately 24 percent, on average. Hence, the control of a newly listed rm is not expected to change hands. In other words, new blockholdings in IPO rms are unlikely to observe. As documented by Arugaslan et al. (2004), monitoring considerations appear not to be important determinants of IPO underpricing. Supporting H4, the proportion of shares held by institutional investors is negative and signicant in the three models. In Indonesian IPO rms, the presence of institutional investors are infrequently observed, where the proportion of their ownership is 4.2 percent, on average. Hence, the nding seems to suggest that institutional investors in IPO rms help promote better corporate governance practices, contributing to mitigating agency issues between the controlling shareholder and minority shareholders. Additionally, the presence of institutional investors can be expected to reduce information asymmetry between the issuer and potential investors, so that the issuer does not need to set a signicantly lower offer price to attain the success of its IPO. This positive relation is consistent with Kiymaz (2000) that addresses the Turkish IPO rms. On the other hand, our result contradicts Lin and Chuang (2011), which argue that institutional ownership in the Taiwanese IPO rms magnies agency conicts between controlling and minority shareholders, leading to greater underpricing. Using the Australian setting, Bird and Yeung (2010) also document such a positive association. Hanley and Wilhelm (1995) argue that institutional investors possess private information regarding rms in which they invest, so that they would use their

information advantage to avoid investments in overpriced IPOs. However, such a proposition seems to apply only in markets where institutional investors in IPO rms are more prevalent. In terms of control variables, rm protability is found to positively inuence the level of underpricing, indicating that investors perceive the high level of performance as a signal of good quality. Additionally, both auditor reputation and underwriter reputation are found to be signicant and negative. This supports the notion that reputable auditors and underwriters play a signicant role in mitigating information asymmetry between the issuer and potential investors. 4.4 Underpricing and corporate control: does the controlling shareholder matter? Claessens et al. (2000) have documented that Indonesian listed rms show the highest ownership concentration among their East Asian counterparts. This indicates that corporate control in the hand of a single large shareholder is a common phenomenon in the countrys capital market. Hence, in further analysis, we analyze whether the type of corporate control inuences the underpricing of IPO rms. Following Claessens et al. (2000) and Setia-Atmaja et al. (2009), the largest shareholder is dened to be the controlling shareholder if he or she holds at least 20 percent of a rms common shares. In other words, if the proportion of shares held by the largest shareholder is less than 20 percent, a rm is considered widely held. Information provided in IPO rms prospectuses enables us to trace a rms ultimate shareholder, to a particular extent, and then determine the type of corporate control, whether the rm is controlled by the government, a family, a foreign entity, a nancial institution, or is widely held[2]. The summary is provided in Table V. In separate regressions, we substitute the variable of ownership concentration with the type of corporate control. The results are reported in Table VI. We address three most common types of corporate control, namely family control, foreign control, and government control, which are indicated using dichotomous variables. To deal with potential multicollinearity problems among these three variables, we run three regressions separately. While family control and foreign control are not signicant, it is revealed that government control positively inuences underpricing at the 5 percent level.
Category Family-controlled rms Foreign-controlled rms Government-controlled rms Widely held rms Financial institution-controlled rms Total sample rms Number of rm 66 20 12 2 1 101 Percentage 65.35 19.80 11.88 1.98 0.99 100.00

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Notes: This table reports the types of corporate control in the sample rms; family-controlled rms are rms whose ultimate shareholder is an Indonesian individual or a privately held, non-listed company; foreign-controlled rms are rms whose ultimate shareholder is a foreign entity; government-controlled rms are rms whose ultimate shareholder is the Indonesian Government or a regional government in Indonesia; nancial institution-controlled rms are rms whose ultimate shareholder is a nancial institution; widely-held rms are rms whose ultimate shareholder is a widely-held rm

Table V. Types of corporate control in IPO rms

MF 39,2
Intercept Board size

Model (1) 0.654 * (1.367) 2 0.053 (2 0.709) 0.358 * * (1.997) 2 0.069 (2 1.103)

Model (2) 0.443 (0.956) 2 0.055 (2 0.729) 0.331 * * (1.888) 0.021 (0.234)

Model (3) 0.672 * (1.325) 2 0.051 (2 0.641) 0.359 * * (2.093)

194

Board independence Family control Foreign control Government control Institutional ownership Firm age Protability Firm size Auditor reputation Underwriter reputation Number of observations R2 Adjusted R 2 F-statistic

2 0.391 * * (2 1.666) 2 0.038 * (2 1.480) 0.001 (1.224) 2 0.009 (2 0.480) 2 0.101 * * (2 2.006) 2 0.075 * (2 1.473) 101 0.206 0.128 2.624 * * *

2 0.350 * (2 1.558) 2 0.032 (2 1.223) 0.001 * (1.364) 2 0.003 (2 0.174) 2 0.100 * * (2 1.995) 2 0.071 * (2 1.364) 101 0.196 0.117 2.469 * *

0.159 * * (1.722) 2 0.344 * (2 1.550) 2 0.055 * * (2 1.936) 0.001 * * (1.681) 2 0.010 (2 0.501) 2 0.108 * * (2 2.114) 2 0.094 * * (2 1.826) 101 0.216 0.138 2.781 * * *

Table VI. Regression of underpricing on different types of corporate control

Notes: Signicance at: *10, * *5, and * * *1 percent levels (one-tailed), respectively; robust t-statistics, based on heteroskedasticity-consistent standard errors, are in parentheses; this table reports OLS regressions of underpricing on board structure, corporate ownership, and corporate control; see Table I for variable denitions; family control is dichotomous, which equals 1 if the rm is family-controlled and 0 otherwise; foreign control is dichotomous, which equals 1 if the rm is foreign-controlled and 0 otherwise; government control is dichotomous, which equals 1 if the rm is government-controlled and 0 otherwise

The retention of an IPO rms shares in the hand of a family seems not to either send signals of the rms quality or reduce information asymmetry. This contradicts the nding of Lin and Chuang (2011), which nd a positive association between family ownership and underpricing in the Taiwanese IPO market. They base their argument on the proposition of Brennan and Franks (1997) that insiders tend to set a signicantly lower offer price to avoid new blockholdings. With respect to foreign control, our result is also contrary to previous ndings that foreign participation leads to improved corporate governance practices (Johnson et al., 2000; Gillan and Starks, 2003), which might signal good quality or reduce the information gap between the issuer and potential investors. In Indonesia, publicly listed state-owned enterprises generally conduct IPOs after a long process of corporatization and, hence, are of relatively higher quality in terms of corporate governance practices and rm performance. These advantages seem

to appear as a signal of good quality for investors, leading to greater underpricing. Hence, this result contradicts the nding of Yu and Tse (2006) who acknowledge that government ownership is negatively related to underpricing in the Chinese market. 5. Conclusion This paper is aimed to examine whether board structure and corporate ownership inuence the level of underpricing of Indonesian IPO rms. We nd that board size has a negative relation to underpricing, albeit of limited signicance, implying that larger boards potentially mitigate information asymmetry between an IPO rm and potential investors. Hence, in an IPO, larger board size is used to reduce uncertainties about rm value rather than to signal the rms quality. Contrary to our hypothesis, board independence is positively and signicantly associated with underpricing. On the one hand, this seems to suggest that independent commissioners on the Board of Commissioners do not play a signicant role in reducing uncertainties about rm value. On the other hand, within the signaling theory framework, a higher proportion of independent commissioners may be perceived as a signal of good quality, where rms possessing independent commissioners are assumed to be aware of the protection of new investors interests. Such rms may also be seen to be ready to fulll capital market regulations in terms of good corporate governance implementation. Consistent with our prediction, institutional investors are expected to improve corporate governance practices and, hence, to lower the degree of information asymmetry, leading to a lower level of underpricing. H3 appears to be the only hypothesis being rejected in this study, as it is found that ownership concentration is not signicantly related to underpricing. This nding contradicts the proposition that the issuer underprices IPO shares to allow oversubscription and avoid new blockholdings. This proposition is not observed within the Indonesian market, since the proportion of shares offered to the public in an IPO is generally low, thereby preventing large new shareholdings that can impose additional monitoring on the rm. However, when the type of corporate control is taken into account in further analysis, it is revealed that government-controlled companies tend to experience greater underprincing. Overall, our empirical evidence suggests that corporate governance structure matter, to a particular extent, to the level of underpricing of IPO rms. The result of this study may be useful for investors in setting expectations regarding the return of their investments in IPO rms in the Indonesian equity market. Nevertheless, the present study is still subject to some limitations. It is suggested that future studies employ a longer time span and data from multiple countries to provide more powerful insights into the association between corporate governance attributes and underpricing. The role of corporate governance attributes in different types of corporate control may also need to be addressed in future research, so that it can be determined whether such attributes are used to enhance good signals or to reduce uncertainties about rm value.
Notes 1. As regulated in the Indonesian Corporate Law, corporations shall have two boards in their organizational structure, namely Dewan Komisaris (Board of Commissioners) and Direksi (Board of Directors). Each of these two boards shall have its own members, so that double membership on the two boards is not permitted. The members of the two boards are elected

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MF 39,2

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or appointed by shareholders in the general meeting. The Board of Commissioners is a supervisory board with at least two members representing the shareholders and is headed by a president commissioner. It has advising and monitoring roles on the Board of Directors, thus its function is totally non-executive. The members of the Board of Commissioners may be afliated to the rm (non-independent) or from outside the rm (independent). The president commissioner may be elected from either non-independent or independent members of the board. Based on applicable capital market regulations, publicly listed corporations shall have independent commissioners of at least 30 percent of the total number of Board of Commissioners members. Further, the Board of Directors conducts the day-to-day management of the corporation and is headed by a president director (comparable to the Chief Executive Ofcer in unitary board structure). The board, which has at least two members, must be responsible to both shareholders and the Board of Commissioners. As such, different from that in unitary board structure, the Board of Directors of Indonesian corporations represents senior management or highest-level executives of a rm. 2. Disclosure on the ultimate shareholder appears to be a problematic issue in the Indonesian corporate governance system. In the prospectus, an IPO rm shall indicate its shareholders, as well as the shareholders of its parent company. Manual efforts to identify the ultimate shareholder, relying on publicly available information, might face difculties. Hence, our identication method is similar to that used by Faccio and Lang (2002). If the controlling shareholder, or the controlling shareholder of the parent company, is an Indonesian individual or a privately held, non-listed company, then such an IPO rm is considered family-controlled. Additionally, if the controlling shareholder of the parent company is a publicly listed company on the IDX, then we trace the ultimate shareholder from the annual reports or nancial statements of the publicly listed rm.

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